Today saw a massive short covering trade occur in the US Treasury market. A broad base of traders got short treasuries over the past few days (long end auction setup trades…and the usual group who just MUST fade every move). Yesterdays weak ADP and ISM data brought in a large buyer of bonds (and a medium size seller of stocks). Today the stocks market went sideways while the Treasury market was rocked…the herd of Treasury shorts was caught and fear overtook all rational thought. There was a very high volume short covering event in the morning that lasted for about an hour and saw 100mm/basis point trade in a straight line “up” (this is 4x normal volume for that time period). While all this craziness was taking place in the Treasury market…the stock market was “unch.” Its as though stock market participants were completely unaware of what was happening in the Treasury market.
3 weeks ago (March 14th), S&P futures opened 1554 while 10yr Treasuty futures opened @ 130-10. Today, S&P futures closed @ 1555 “unch from 3 weeks ago” while 10yr treasury futures closed @ 132-26 (thats 2 1/2 POINTS on a 7yr piece of paper).
3 weeks ago the relationship between stocks and bonds was priced at fair value. Today, the stock market hasn’t moved and the Treasury market has been ROCKED. On a relative value basis, the Treasury market is now 20 basis points rich compared to the stock market. To put that in S&P terms…the S&P is currently trading 1555….if the S&P were to move to accommodate the move in the Treasury market…the S&P would need to trade 1450…that’s 100 POINTS lower (or 6.4%). This is the most rich these markets have been relative to each other in years. The current correlation regime has lasted 9 months (treasuries and stocks have been dancing with each other in a stable fashion for the past 9 months). Even adjusting for regime change, this move today is the richest these markets have been even during this current 9 month regime.
So, either the regime between bonds and stocks has just changed…or the market has just given traders with cash on the sidelines a gift. History has taught us that regime changes don’t happen very often…and the smart move for a trader has been to fade these attempts to “break the regime.” Its true that someday the regime will shift, and we will enter a new regime, and fading a move like this will lose money. Do you think that just happened? Do you really think we just entered a new regime? Its true that Japan just embarked on a new round of QE…and it is a 2.5 times the size of current US QE, and North Korea is threatening war. Should that break the regime of the relationship between US stocks and US bonds? Someday, something will do just that. The question for traders is…do you think the regime just shifted.
Personally, I’m not convinced, and so i faded this move at the close by selling ES and ZN (S&P futures and 10yr Treasury futures) at a ratio of 4 ES vs 11 ZN contracts. If you are trading a 1mm$ account and wanted to put 1/3 of your margin to work on this leveraged trade, then you would sell 40 ES @ 1555 and sell 110 ZN @ 132-26 (thats 317k of margin…so 1/3 of your futures account as an example). The trade to fade this move is to sell both (sell ZN and Sell ES), which is exactly what I’ve done.
Follow @govttrader on twitter to see what happens with NFP and next weeks long end (10yr and 30yr) treasury auctions. Did the regime just change…or did the mkt just provide me a gift? My expected timeframe for this trade is 1-2 weeks. As always, my expectation for the future will determine when i actually exit this trade.
Disclosure: I am not advising anybody do this trade with me…this is a leveraged trade, and short positions have the theoretical potential for unlimited losses.